Common pitfalls in CRE loan portfolios

The challenge of incomplete information

At the outset of a new financing, evaluating the market for the highest loan proceeds, lowest rates, and best terms is a logical starting point. A thorough appraisal should also incorporate the cost of terminating existing debt and derivatives (in either a refinancing or forward hedged scenario), the impact of uncertain future interest rates, and changes to the asset hold time horizon leading to potential breakage costs associated with an early exit or refinancing.

These can be challenging to identify and assess in a vacuum. Getting this analysis wrong may not cause immediate issues, but does introduce increased risks of future unanticipated costs, with a potentially punitive impact to returns.

Common debt and derivatives questions from commercial real estate investors

• Which debt and hedging strategy is most suitable for my business plan? The most thorough approaches compare critical metrics such as effective cost of debt, levered equity net present value, and levered equity internal rate of return. These are calculated across a range of interest rate environments and hold periods. Probability weighting these key metrics toward the scenarios that most closely align with the business plan results in a robust and quantitatively sound result. This allows examination of outcomes and addresses the question: “what happens if things don’t go as planned?”
• How can I more precisely project the path of interest rates over the life of my loan? The path of interest rates over time determines both interest paid and future potential breakage costs. The forward curve is a reasonable starting point, but history would suggest that relying solely on this would be insufficient. A complete analysis will consider a range of interest rates scenarios to draw more accurate conclusions to determine the most appropriate strategy.

• How can I best communicate debt and hedging alternatives and recommendations to a management or investment committee? Converting multivariate numerical analysis from an Excel spreadsheet to a presentation with succinct narrative is challenging. The risk of omitting key details or exposures is high, and the outputs can be complex, making it difficult to draw beneficial conclusions. The best illustrations are usually in graphical form – this can clearly describe key financial inputs, flexed to accommodate alternative interest rate environments, and drawing the reader to the most suitable debt and derivative structures.

• How should I calculate the prepayment or make-whole provisions in my loan? Prepayment and make-whole clauses differ considerably across lenders, jurisdiction, and debt structure. For instance, a fixed-rate loan may come with a considerably different breakage penalty than a floating-rate loan hedged with a pay-fixed swap despite the two having comparable all-in coupons. Correctly addressing the nuances not only requires bespoke calculations on each transaction, but also access to data such as government bond rates or swap rates which drive the calculation.

• Is there a way to access live valuations of my existing derivative positions? Derivative valuations are primarily driven by spot interest rates, volatility, and the prevailing forward curve, which trade live in the open market. The byproduct of this market dynamic is a constantly changing valuation which can move materially depending on the type of product, rate, remaining duration, and market conditions. If the valuation used in a debt and hedging analysis is erroneous, then the output will be incorrect, leading to sub-optimal decisions.

There is no way to guarantee the most appropriate debt and derivative structure for each investment, and each transaction requires a bespoke process reflective of the market conditions at the time. The best processes incorporate sensitizing inputs and assumptions and deploying a range of tools to capture and quantify future uncertainty.

The critical question: are you asking these questions at the outset of a new financing? And do you have the tools to answer them in real time and across your entire portfolio?